The impetus behind the Qualified Opportunity Zone program is two-fold.
First, certain lower-income communities lack necessary resources, such as capital, to help in revitalization and job creation. Second, U.S. investors accrued trillions of dollars in unrealized capital gains from asset sales. The purpose of the program is to redirect those capital gains to economically challenged Qualified Opportunity Zones (QOZs). Investors are encouraged to participate in the program through temporary tax deferrals on capital gains.
Though the program is fairly straightforward, one question that comes up is: what gains qualify for opportunity zones? The answer to this question is: any capital gain generated from a capital asset sale is eligible to be invested in a Qualified Opportunity Fund which, in turn, supports QOZ improvement and/or development.
The other question that occasionally comes up is whether investors can place more than just capital gains into an Opportunity Zone. The answer here? No. The program was created specifically to direct the above-mentioned, untapped, trillions of dollars in capital gains to low-income communities in need.
What is a Capital Gain?
A capital gain is created when a capital asset -- such as securities, real estate, art, or currency -- sells for a higher price than what was originally paid for it. When it comes to taxes on the gain, however, the discussion isn’t quite that simple, because there are differences between a realized gain and a recognized gain.
The realized gain is the net sales price of the asset, minus the adjusted tax basis. The adjusted basis involves increases or decreases to the asset’s value, which might consist of wear and tear, or monies spent on improvements. The recognized gain, meanwhile, is the taxable portion of the realized gain.
For instance, if you purchase a certain stock for $1,000, and sell it five years later for $5,000, your recognized capital gain on that sale will be $4,000. Adding in a $150 brokerage fee means your realized capital gain will be $4,000 - $150 = $3,850. But the IRS will tax the entire $4,000, and allow you to take the $150 as a deduction against ordinary income.
Through the QOZ program, the IRS allows you to defer taxes on that capital gain.
How Capital Gains Operate With QOZs
Depending on the basis, you could pay up to 20% of capital gain taxes on assets held for longer than one year. If you hold your asset for less than one year, the gain will be taxed as ordinary income, up to 37%. And, no matter how long you hold that asset, if you invest the capital gain into a QOF, you won’t be taxed on it until the end of 2026.
There is another QOF tax benefit as well. Your capital gain can be reduced by 10% if it remains in the QOF for at least five years. Taking the example above, if you keep the $4,000 gain in the QOF for at least five years, 10% is knocked off, leaving a $3,600 capital gain. If you keep that money in the QOF for at least 10 years, you owe no capital gain taxes.
What Investors Need to Know
While you can receive a nice tax deferral and basis reduction through a QOF investment, the IRS doesn’t hand out these goodies without some conditions attached. Certain deadlines must be followed to ensure tax deferral.
Normally, when you sell your asset, you have 180 days to reinvest the capital gain in a QOF. However, in response to COVID-19, the IRS issued Notice 2020-39, which extended this deadline. If your asset sale fell between April 1, 2020 and Dec. 31, 2020, you have until Dec. 31 to reinvest the capital gain into a QOF to take advantage of the program.
Just the gains, ma’am
The question, “what gains qualify for Opportunity Zones?” has a straightforward answer. Capital gains, only. The QOZ program was put into place, not so much as an overall investment program, but as a way to tap into trillions of private investment dollars. Putting those gains into Qualified Opportunity Zones means you can benefit from nice tax advantages, while assisting in the process of community economic improvement.
There are material risks associated with investing in QOZ properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal.
Past performance is not a guarantee of future results. Potential cash flow, returns and appreciation are not guaranteed.
IRC Section 1031 is a complex tax concept; consult your legal or tax professional regarding the specifics of your particular situation. This is not a solicitation or an offer to sell any securities. There is no guarantee that the investment objectives of any particular program will be achieved.
